Credit derivatives are financial vehicles which were developed in the 1990's as a means for transferring the risk of the total return in a credit transaction falling below a stipulated rate, without transferring the underlying asset. More particularly, a credit derivative is a financial arrangement which allows one party to transfer credit risk of a particular asset (which it may or may not own) to one or more other parties.
An example transaction is shown in FIG. 1, where a protection buyer 10 (also referred to as an originator) has contracted with a protection seller 14 to transfer credit risk of a reference asset 12. Protection buyer 10 need not own reference asset 12, instead, protection buyer 10 need only have credit risk associated with its interest in reference asset 12. The transaction involves the payment of a negotiated fee from protection buyer 10 to protection seller 14. In exchange, protection buyer 10 receives a contingent payment which occurs in the event of the occurrence of a predefined event. Typically, the contingent payment is payable upon the occurrence of a “credit event” (such as, for example, bankruptcy, insolvency, receivership, material adverse structuring of debt, failure to meet obligations when due, etc.) associated with a specified “reference obligation” of a reference entity.
Standard form International Swaps and Derivatives Association (ISDA) Credit Events used for such credit derivative agreements assume that the reference entity is, or will be, contractually obligated to a reference obligation. This is not necessarily the case, however.
Because the obligation to pay the contingent payment is based on contractual relationships among various parties, it is important to accurately understand (on an ongoing basis) the current status of the parties and the reference obligations. Examples of the difficulty of maintaining an accurate understanding of the status are, unfortunately, becoming too common. For example, in 2001, Swiss Re Financial Products Corp. sued XL Insurance Ltd. over its refusal to pay a $20 million claim made by Swiss Re in connection with the bankruptcy of Armstrong World Industries. The suit was based on the language of a credit swap agreement. XL maintained that it issued a credit insurance policy covering the debts of Armstrong Holdings, not Armstrong World Industries, and therefore refused to pay the claim. In particular, XL maintained that a credit event occurred as a result of the bankruptcy of Armstrong World Industries, and that the credit event did not extend to Armstrong Holdings. Put simply, Swiss RE (and others) suffered losses because the confirmation documents associated with the credit agreements referred to “Armstrong Holdings Inc.” rather than “Armstrong World Industries”, even though (in some cases) the reference obligation details were those of Armstrong World Industries bonds.
Other issues are associated with the accuracy of such credit risk agreements. For example, ISDA Credit Events, if interpreted literally, cannot be triggered if the reference entity has no material indebtedness. Accordingly, it would be desirable to provide systems and methods to ensure that such agreements are based on accurate characterizations of reference entities and reference obligations. It would further be desirable to provide systems and methods for updating information identifying reference entities and obligations throughout the life of an agreement.